Contracts sometimes specify the financial consequences of breaching a particular clause, often by detailing in advance the damages payable by the guilty party.

When drafting or negotiating these clauses, great care needs to be taken to avoid framing them in a way that risks them being struck down as unenforceable penalty clauses.

The traditional test adopted by the courts in deciding what is permissible has been to examine whether the specified damages are a genuine pre-estimate of the loss which flows from the breach.

In late 2013 the Court of Appeal of England and Wales commented that the courts in recent years have adopted the broader test of examining whether a clause is extravagant and unconscionable, and whether its main purpose is to deter a party from breaching the contract.  If the amount to be paid or lost is out of all proportion to the loss attributable to the breach then it is likely to be considered penal as it has been designed to act as a deterrent rather than compensatory.  The Court also stated that if there is a commercial justification for a clause (such as a modest increase in interest in respect of a defaulting loan) then even though it may not contain a genuine pre-estimate of loss it is nevertheless not considered to be penal.

The Irish High Court also addressed penalty clauses in a case involving ACC Bank and Friends First in late 2012 (previously discussed here).  In that case a clause provided that if Friends First defaulted in the payment of any sum payable under a loan it had to pay interest of 6% per annum.  The Court stated that in Ireland the approach taken to penalty clauses is the traditional test outlined above.  It did however refer to the approach emerging from recent English case law and commented that it may not be a departure from the traditional test, but rather a modern application of it.  In this case, however, the Court decided that the 6% interest rate was penal and therefore unenforceable.  The penalty could have been triggered even if one payment of any amount (however small) was missed.  This could not, therefore, be considered a genuine pre-estimate of the loss resulting from the breach.

Both cases illustrate the need for great care when including these types of clauses in a contract and provide useful guidance on how they should be approached.